The archived blog of the Project On Government Oversight (POGO).

Oct 05, 2009

Public-Private Partnerships Are Set to Begin, but Will the Public Really Benefit?

The controversial Public-Private Investment Program (PPIP)—in
which the government is partnering with private investors to purchase the toxic
loans and securities that are clogging up the balance sheets of many financial
firms—is finally ready to begin. The Treasury Department hasannounced that five of
the nine
asset managers selected for the PPIP’s Legacy Securities Program have each
raised at least $500
million in equity from private investors, the minimum required to get
official approval. This commitment in private equity will be combined
with equity and debt financing from Treasury to form the Public-Private
Investment Funds (PPIFs) that will be purchasing and managing the legacy
securities.

Although the PPIP has been scaled back since it was first
announced, Treasury is still setting aside $30 billion in TARP funds for the
program, in hopes that it will reignite the market for real estate-related
assets, facilitate price discovery, increase investor confidence in the firms
that carry these assets, and encourage the firms to increase lending to
consumers and small businesses. But now that the first wave of private fund
managers has been given the green light to purchase legacy securities, we
wonder if the program will have as much impact as Treasury claims, and if the
public really stands to benefit from these “partnerships.” As POGO and others
have repeatedly pointed out, there are still a host of unresolved issues
related to the PPIP:

Incentives skewed in favor of private investors

As
soon as the PPIP was first announced, commentators such as Joseph Sitglitz and Jeffrey Sachs raised concerns that the generous
subsidies provided by the government would skew the incentives in favor of
private investors. Although the government and the investors will split
any profits 50-50, it’s the government that will have to incur major
losses if the investments go badly since the government’s also providing
debt guarantees. Supporters of the TARP have applauded the recent news that the government made a profit when
some of the big banks repaid their TARP funds, but the PPIP is an area
where taxpayers could still take a big hit.

Potential for conflicts of interest

The
Special Inspector General for the Troubled Asset Relief Program (SIGTARP)
has had its eye on the PPIP for months now, sounding the alarm about the
potential for conflicts of interest, collusion, and money laundering. In
its most recent report to Congress, the SIGTARP announced that
Treasury had adopted many of its recommendations, as reflected in the recently updated conflict of interest rules and ethical
guidelines. But the rules are still far from perfect.

Of particular concern to POGO is the potential for conflicts of interest involving BlackRock
and some of the other asset managers that have a significant financial
interest in the same types of securities that they’ll be purchasing and
managing for the PPIFs. One simple, albeit incomplete solution would be to
implement internal firewalls that would prevent the employees working for
the PPIFs from sharing insider information with the employees managing
non-PPIF funds. But the latest SIGTARP report revealed that Treasury won’t
even take this basic step, leaving the PPIP open to conflicts of interest
that could result in financial losses for the government and an unfair
competitive advantage for the private asset managers.

Lack of participation by firms that hold legacy securities

An
August report by the Congressional Oversight Panel observed
that “the issue underlying the PPIP is the same as the question underlying
virtually all discussions of troubled assets: valuation.” At the end of
the day, even though the PPIFs are almost ready to go, Treasury still
needs participation from the firms that are holding the legacy securities.
And many of these firms are worried that the PPIFs will
underpay for their assets, forcing them to incur losses on their books.

It’s possible that some banks are steering clear of the PPIP because of a
recent decision by the Financial Accounting Standards Board—under pressure from Congress and the financial services
lobby—to revise a key “mark-to-market” accounting rule that
would have otherwise forced banks to report major losses on their troubled
assets. Thanks to the rule change, banks now have more leeway to use
creative accounting when estimating the value of the assets they hold on
their books. Harvard Law Professor Lucian Bebchuk wrote in June that the new accounting rules “strongly
discourage banks from selling any toxic assets maturing after 2010 at
prices that fairly reflect their lowered value. As long as banks don’t
sell, the policies enable them to pretend, and operate as if their toxic
assets maturing after 2010 haven’t fallen in value at all.” If this is the
case, it seems likely that the PPIP will continue to stall due to a lack
of participation from banks that would rather hold the legacy securities
on their balance sheets and avoid booking any losses.

Many of these same concerns also apply to the other half of
the PPIP, the Legacy Loans Program (LLP), which targets whole loans rather than
securities and is being administered by the Federal Deposit Insurance
Corporation (FDIC). A few weeks ago, the FDIC announced
a pilot sale in which Residential Credit Solutions, a Houston-based lender,
will purchase mortgages from a failed bank that the FDIC is holding in
receivership. The transaction is fairly complicated, but the bottom line is
that the FDIC is providing most of the equity and debt financing for the sale.
In addition to the generous government subsidies, severalcommentators have pointed out that there is something very
strange about this deal: the investor will be purchasing assets from a bank that
has already failed.

If the FDIC plans to continue facilitating the sale of
assets for failed banks that it’s holding in receivership, this could have one
positive side effect: any investors who overpay for the bank’s assets would
also be helping to replenish the FDIC’s sorely
depleted Deposit Insurance Fund. But a recent
paper by Professor Linus Wilson shows that inflated prices won’t actually
benefit the Deposit Insurance Fund in the long run. More importantly, we’re not
sure how any test with a failed bank will produce useful results for banks that
are still in existence or advance the government’s goal of increasing lending.
And as the Congressional Oversight Panel report points out, the
continued delay in assisting banks with legacy loans could have serious
consequences for smaller and community banks, which tend to hold more whole
loans than securities and are likely to be hit hard by any rise in defaults.